Economic Update - March 2nd, 2015

Economic Update – March 2015

by Infocus Author

The Big Picture

The Big PictureJust when things were starting to look predictable at Central Bank level, spanners from all directions were thrown into the works. India and Denmark had already got the ball rolling with rate cuts when, on January 16th, the Swiss National Bank (SNB) walked away from its cap on the Swiss franc against the euro.

Any move like that would always be a surprise but the three year deal was strongly supported in a statement by the SNB only two weeks before. Traitor may well have been uttered as the franc ‘popped’ a massive 41% on the news. These days, a 1% change in one day for most currencies is thought to be big. 41% (even though it later pulled back) ruined some retailer investors, brokers and hedge funds.

So why did the SNB do it? Who knows? But they knew the European Central Bank (ECB) was due to meet and probably announce a money printing scheme that would undermine the value of the euro. Such an event would have placed further pressure on the Swiss franc and something had to give.

Days later, just as we were getting used to the full impact of the SNB decision, the Canadian Central Bank surprisingly cut its interest rate from 1% to 0.75%. Not one economist expected this decision – just like with the SNB. The Canadian dollar plummeted 2% on the news and took our dollar with it.

However, Canada and Australia have very different economies. Both are heavily reliant on commodities, have large land masses with relatively small populations and are related by the Commonwealth games. The big difference is that Canada is an exporter of oil while Australia is a net importer.

Canada loses income from low oil prices. Australia gains by leaving consumers better off from lower oil prices. Of course there are some winners and losers in each country but the big picture is that we are much better off than Canada on this account.

The trifecta of central bank surprises came from the ECB when it not only announced ‘QE’ (Quantitative Easing meaning money printing), it overachieved – at last! Their programme is much bigger and better than was expected.

Printing money doesn’t guarantee growth – but it does buy time for governments to do what governments must do. We probably have a year or more before we know if it is working. In the meantime, Europe is good.

That didn’t stop Greece voting in a new government that is against ‘austerity’. Nobody likes austerity but one has to face the music when one gets into debt. But the low bond rates across Europe – and the better shape that many countries are now in – means Greece is no longer a major issue for people living outside of Greece. Contagion is not expected this time around.

So with the United States (US) having undergone QE for years, Japan having recently jumped in with both feet, China having its own version – and many other countries doing much the same – what is going on?

At the moment, every county would like to devalue its currency. A lower currency means cheaper exports and more expensive imports – so a country gets the balance sheet in order and devalues their debt! But everyone can’t devalue. It is a race to the bottom.

It is, of course, the same reason why our Central Bank – the RBA – wants a lower currency. So far it has relied on talk (or jaw-boning) but it might act in some way. However, our economy has done so much better than most over the last seven or eight years, we are less reliant on these quick fixes that may or may not work.

Asset Classes

Australian Equities

January was a bumpy month, but it finished strongly – up +3.3% on the month. Stocks reliant on oil and iron prices were hit hard but some stocks reached all-time highs – such as CBA. We see the ASX 200 reaching 5,850 by the end of 2015 with a possible high of 6,200 during the year. The index currently stands at 5,588.

We have our index modestly overpriced by +1.2% in the short-run but our long-run view is that we are about 5% underpriced.

Trading is usually light in January because of the summer holiday season. As a result, volatility can often be elevated and it was. But volume came in big and strong in the last week reinforcing the market strength.

The fall in the $A is thought to benefit many exporting companies. Lower oil prices could help companies outside of the resources sector. But, at this point, our broker-based forecasts point to an ‘average’ year of about 6% capital gains plus 5% dividends and maybe 1.5% franking credits. The total expected return is strong but the headline number for the ASX 200 might not please as much as some would like.

The keys will be revealed in the February reporting season as companies map out their expected futures. Since it takes some time for currency and commodity price effects to ‘pass through’, any real benefits may not become obvious until the August reporting season.

Telstra has been a stand-out performer. Its dividend yield has fallen below 5% but there has been much commentary that Telstra is also becoming a growth stock – based on new technologies and a highly skilled management team. Interestingly, the fall in the BHP stock price is almost lifting it into a yield play with an expected dividend of 4.4%!

Foreign Equities

Wall Street had a poor month with the S&P 500 falling 3.1% while the London FTSE climbed +2.8% in line with the ASX 200. The German DAX rocketed up by +9.1%. The story that played out was heavily influenced by the ECB decision to start stimulus.

Reporting season in the US is not going as well as many had expected or hoped for. Many say it is not the strength of the greenback but a failure of companies to grow their businesses that caused the fall in equities.

Bonds

With the ECB starting its 1.1 trillion euro QE programme in March, bond yields in many countries are particularly low. The US 10 year Treasury Note is yielding about 1.7%.

Our 10 year government bond yield is just over 2.5% and above those of Spain and Italy. It was only a few years ago that the so-called ‘PIGS’ countries, that include Spain and Italy, had yields of around three times more than now.

Interest Rates

The volume of chatter on whether the RBA will cut rates at their February 3rd meeting was increasing until the inflation data came out at the end of January. ‘Headline’ inflation did come in low for the quarter at +0.2% but that was heavily influenced by oil prices.

The RBA’s preferred ‘underlying’ inflation read that trims out some items like oil, came in at +0.7% – an unexpectedly high read.

But on January 28th, a journalist predicted a cut the week after and that had a major impact on market expectations. Using market pricing, the chance of a cut went from about 40% to about 65% in one day!

Given the conservative nature of the RBA, we think it seems unlikely it will move without warning – but, of course, no one can ever completely rule out a cut or a hike. Moreover, the labour market looks to be improving without a cut.

We believe it is quite possible that rates will be on hold all year but a 0.25% change either way would not greatly affect most Australians. Our call remains that the next move could be up – but in 2016.

The statement from the Fed pushed out market expectations for a hike in the US from June to around September. Again, we think no change this year is the more likely outcome. If the US does hike, it would probably only make a small increase to say 0.25% or 0.5% and leave that rate on hold for quite some time. Having a 0% – 0.25% rate isn’t a good look for the biggest economy in the world.

The main reason why we are not expecting a hike any time soon is that the US did raise rates too soon in 1938 sending the economy back into recession. The US economy is strong but not massively so.

Other Assets

Iron ore prices continue to be depressed and volatile. Recent data shows that Australia gained a big market share in ore against countries other than Brazil for sea-born imports into China. Since this was apparently a desired outcome, further falls in price from increasing supply might slow down.

Oil prices (Brent) fell another -3.2% in January but it would have been much worse had they not risen +12.5% in the last week! WTI oil was down 9.7% on the month. OPEC is predicting a rebound in prices in 2016. Gold prices took a turn for the better in January climbing +7.3% on the month.

Regional Analysis

Australia

Taken out of context, our recent, strong labour market data and moderately high inflation reported in January would be what one might expect from a robust economy. But it doesn’t feel like that, does it? As the squabbling continues in Cabinet, it looks more like Australians are weighed down from a lack of leadership rather than economic reality.

After the so-called labour market data issue in mid-2014, we now have an unemployment rate that has improved in steps from a high of 6.3% to 6.1% for the latest read.

Employment data was also strong with +41,600 new jobs created in December, with more people joining the workforce in search of employment.

Although the RBA focuses on the underlying rate of inflation – which came in at +0.7% – in setting interest rates, the inflation read we all face is the headline rate of +0.2%. With another fall in oil prices that came in since the inflation rate was calculated, consumers are in for more good times at the bowser – for now.

China

China’s Purchasing Managers’ Index (PMI) for manufacturing came in on the 1st February at 49.8, down from the previous month which was 50.1. China exports and imports both beat expectations.

Importantly, Premier Li gave an address at the Davos World Economic Forum assuring us that China will not have a hard landing. The PMI and trade data are consistent with Li’s view.

Imports of iron ore climbed as a market share from Australia, but took a nose dive from the rest of the world (ex Australia and Brazil). The BHP-RIO-Vale ‘squeeze out the expensive producers’ policy has worked by increasing supply to force down price.

U.S.A.

The US had another strong month with employment data. There were +252,000 new jobs added and unemployment fell to 5.6% but wage growth was again negative.

The US also had their best read on consumer confidence in 7 years. Not all data are great but this isn’t a country that is falling over. GDP growth did miss estimates at +2.6% (annualised) for Q4 compared to the revised +5.0% for Q3. However, growth figures go through two revisions before the next number drops and recently those revisions have largely been up. But Wall Street fell sharply on the news.

Europe

Mario Draghi, the ECB president, famously said he ‘would do what it takes’ a couple of years ago. At last he delivered – and in spades. Money printing does not solve real world problems but it does buy time. His plan goes at least until September 2016. The heat is off.

Spain just recorded its 6th quarter of strong economic growth and it is now at levels not seen since 2007!

The problem with Greece voting in a left wing government that is against ‘austerity’ is not what will happen in Greece but what might happen in related countries’ elections in the near future. Is Spain ahead of the curve?

Of course no one likes austerity – and nobody should vote for it (at least willingly) – but when you have maxed out your credit card somebody has to take the loss – the borrower or the lender. At least the SYRIZA party seems to be a reasonable group of left wing people who needed another party to form government. Problem contained!

But the big danger is, Europe has nothing left in the bag if QE doesn’t work to buy enough time. With 12 – 18 months breathing space, investors have time, but time can run out.

Rest of World

The problems in the Middle East that are spilling over into the rest of the world are not going away any time soon. But the possible actions and the consequences are not the stuff for economists. We choose not to comment.

Japan did raise its GDP growth forecast to over 2%, which is not that bad. Canada is joining Russia, Venezuela and Nigeria as those countries are suffering from low oil prices.

In December, Russia hiked its key interest rate from 10.5% to 17% in one go. A month later it dropped that same rate down to 15%. The rouble is in trouble. There seems to be no easy fix for Russia with oil prices and sanctions front of stage.

The best part of the Davos ‘World Economic Forum’ that just concluded was an OPEC chief – and OPEC has controlled oil prices since 1973 – stating that oil prices will stay around current levels for 12 months and then rebound. If he doesn’t know when this will happen, who does? So why didn’t that presentation get more airplay?

*Ron Bewley(PhD,FASSA)– Director, Woodhall Investment Research

Important information

This information is general information only. You should consider the appropriateness of this information with regards to your objectives, financial situation and needs. Infocus Securities Australia Pty Ltd ABN 47 097 797 049 AFSL and Australian Credit Licence No. 236523 trading as Infocus Wealth Management.